The Principle of Microeconomics

by Catherine Capozzi; Updated September 26, 2017

Unlike macroeconomics, which studies the economy from the top down by evaluating government policies and monetary theory, microeconomics views the economy from the bottom up. Microeconomics is the study of how firms and individuals operate. More importantly, understanding the guiding principles of the market and firm behavior helps economists make predictions.

Significance

The principles of microeconomics allow firms and individuals to make better decisions. For instance, business economists who predict a rise in fuel costs can advise firms to switch shipping methods, increase delivery fees and cut delivery routes to certain locations. Similarly, someone who studies microeconomics will understand that a rise in fuel prices, an inelastic good, means consumers now have less money to spend on other items, such as MP3 players.

Types of Firms: Perfectly Competitive

Microeconomics is founded on the principle that firms operate to maximize profit. This incentive affects the ways in which firms produce goods, set prices and compete with other firms. The type of market structure is a primary predictor of a firm's behavior. A competitive market means firms can enter and exit the industry, and basic rules of supply and demand dictate prices. In this market structure, firms are “price takers,” meaning individual businesses do not have the power to set prices.

Types of Firms: Oligopoly

An oligopoly, on the other hand, is the presence of a handful of firms in a single industry. The airline industry is a good example of an oligopoly. However, since agreeing with other companies about setting prices, an activity known as collusion, is illegal in the United States, oligopoly firms are also price takers. In fact, Nash’s Equilibrium Theory states that companies in an oligopoly drive the price of goods and services to the lowest possible price in an attempt to undercut competition. Maintaining profitability is difficult in this type of market structure. Monopolistic competition means only one or two firms operate in an industry.

Types of Firms: Monopoly

Unlike the other two market structures, monopolistic companies can set the price of goods and services. Microsoft is an example of this market structure. Because it has few competitors, Microsoft can set the price of its products with the assumption that customers will accept the price. Monopolies also form when the cost of entering business is cost-prohibitive. Starting a nuclear power plant is a good example of a cost-prohibitive business. William McEachern, author of “Microeconomics: A Contemporary Introduction,” explains that the government steps in to regulate natural monopolies, such as power companies, transportation firms and phone service providers.

Identification of Individual Behavior

Just as firms seek to maximize profit, individuals seek to maximize utility, or satisfaction. Individuals try to use their scarce resources in a way to better themselves. Economists try to predict the ways in which people accomplish this fundamental task. One method is by determining the consumer’s reaction to a change in price: if a significant number of people stop buying one product and switch to another because of a price increase, the good is deemed as highly elastic. If the consumer’s purchasing habits remain unaffected by a price increase, the good is inelastic. Students of microeconomics also study how individuals respond to a rise or fall in personal income. In some cases, a rise in income means a person works harder to earn more money. In other cases, the person chooses more leisure. The type of goods a person buys is also studied. For instance, more luxury goods, such as expensive cars and handbags, might be purchased upon a rise in income, whereas inferior goods, like store-brand soup, might be purchased due to a fall in income.

Resources

About the Author

Since 2008 Catherine Capozzi has been writing business, finance and economics-related articles from her home in the sunny state of Arizona. She is pursuing a Bachelor of Science in economics from the W.P. Carey School of Business at Arizona State University, which has given her a love of spreadsheets and corporate life.